Analysis: Auditor defense may have holes in Deloitte case

A favorite defense of auditors against securities lawsuits may have some holes when applied to a massive case against Deloitte Touche Tohmatsu Ltd stemming from the subprime mortgage crisis.

The world's largest accounting and consulting firm, Deloitte on Monday was accused of failing to detect fraud during its audits of Taylor, Bean & Whitaker Mortgage Corp, one of the biggest private mortgage firms to collapse during the U.S. housing crash.

The complaints were brought by a trustee overseeing Taylor Bean's bankruptcy and one of the company's subsidiaries in a Miami Circuit Court, claiming a combined $7.6 billion in losses.

It's always difficult to believe that an auditor that's been auditing for seven years or more during an alleged ongoing fraud had no red flags, said Andrea Kim, a partner at Diamond McCarthy LLP in Houston.

The lawsuit is just the latest of a spate of troubles for Deloitte and the other big four auditors -- Ernst & Young, KPMG and PwC. They also face a threat to their business model as the European Commission mulls a plan to force them to split off their consulting business and rotate clients.

Auditors have been favorite targets of plaintiffs trying to recoup money lost on alleged frauds during the global financial meltdown, though such cases have run up against an array of legal hurdles, with many being dismissed or settled for relatively small amounts.

Plaintiffs' lawyers have argued that as gatekeepers, auditors have a duty to be vigilant at rooting out fraud.

RED FLAGS BRING LEGAL DUTY

If they see something they need to report it, said Jacob Zamansky, founder of Zamansky & Associates, a law firm specializing in securities fraud. If they consciously ignore red flags, they could be held responsible as an aider or abettor to the fraud.

A key defense is the so-called in pari delicto, or equal fault principle, used when a company being audited was equally to blame for wrongdoing.

It is very fast becoming a law of this nation, which is a tremendous protection for the Big Four, said Kim of Diamond McCarthy.

However, Steven Thomas, an attorney for the plaintiffs, said his case rests on solid legal ground. He said that a key bankruptcy decision holds that under Florida law, the in pari delicto defense does not apply in cases in which the auditor has a duty to detect fraud and in which there were innocent board members who could have been alerted about the fraud.

They (Deloitte) had a public duty to detect the fraud, Thomas said. They didn't do their job, and that's what we're going to prove.

Jonathan Gandal, a spokesman for Deloitte, said on Monday the plaintiffs in the case were companies through which convicted felon Lee Farkas and his co-conspirators committed their crimes.

Lee Farkas, the former chairman of Taylor, Bean and Whitaker, was sentenced to 30 years in prison in April for his role in the bank fraud.

The bizarre notion that his engines of theft are entitled to complain of injury from their own crimes and to sue the outside auditors they lied to defies common sense, not to mention the law, he said in a statement.

The in pari delicto principle, which has led to dismissals of some big auditor lawsuits in New York, is alive and well in Florida, said Thomas Tew, a defense lawyer at the law firm Tew Cardenas in Miami.

In cases involving fraud, I personally believe that it's almost impossible to say that an accounting firm, for instance, should be held liable for audits that were manipulated by crooks, he said.

DELOITTE NAMED IN OTHER SUITS

One complication for trustees is that when they bring a lawsuit, they step into the shoes of the allegedly wrongdoing corporation, said Michael Young, a partner at Willkie Farr & Gallagher who specializes in accounting-related cases.

So a trustee lawsuit against an auditor boils down to the contention that the auditor didn't tell the wrongdoing company that it was doing something wrong, Young said.

A key issue will be whether the Taylor Bean trustee can present itself as separate from the company, said Jeffrey Davis, a bankruptcy professor at the University of Florida's law school.

It may be that the trustee can re-characterize their claim to get around the in pari delicto defense, said Davis. That's the game that's afoot right now.

The EU's proposal to force the Big Four to split off their consulting business and rotate clients would affect all of the Big Four firms, but would be especially harsh for Deloitte, which just edged ahead of PwC as the biggest of the Big Four on the strength of its consulting revenues.

Deloitte has also been named in other big lawsuits stemming from the credit crisis, including one involving its audits of Bear Stearns, which collapsed after suffering enormous mortgage losses, and another involving Washington Mutual, the biggest bank to fail during the credit crisis.

These hindsight claims asserting that the independent auditors should have predicted the dramatic and unprecedented decline in the housing market that shocked the entire industry are meritless and illogical, Gandal said.